Why I&rsquo;m &ldquo;Contrarian Trading&rdquo; the US Dollar

In a recent article, I mentioned that I purchased the dollar through the PowerShares US Dollar Bullish ETF (UUP). My timing in the short term (less than a month) may not be perfect, but I am willing to step in at the current prices with the expectation of higher prices in the intermediate term (one to six months). I am still bearish on the dollar in the long term (one year+), but probably not for the reasons most would think.

Why Be Bullish Now? Isn't “Quantitative Easing 2.0” Coming?

The primary argument for a lower dollar is Helicopter Ben (Bernanke)'s "promise" for QE 2.0, which will further debase the currency. Yet, the crucial question in any trade is not whether a certain future event will happen, but whether or not that expected event is priced in. By my estimation, QE 2.0 is certainly priced in, and we are beginning to see some outlandish calls on the total quantity. Former Bush economic adviser Marc Sumerlin publicly stated that the Federal Reserve needs to pump $6 trillion -$7 trillion into the US economy to have a meaningful impact. I see this possibility as a near impossibility. I only address it as a sign of the level of dollar pessimism and ridiculous easing expectations. The Fed's balance sheet currently stands at $2.3 trillion, up from $800 billion pre-crisis. If the Fed has only bought up $1.5 trillion in assets since the crisis struck, it is extremely unlikely they aggressively expand to the levels Sumerlin is calling for. The legitimacy given to these high-end calls leads me to believe a smaller amount of QE must already be factored into current market prices.

Many relevant minds are announcing their opposition to further quantitative easing. Pimco's Mohamed El-Erian believes further QE will be "ineffective." Renowned economist Joseph Stiglitz recently stated that "Additional monetary stimulus will clearly not solve the problems caused by lack of global aggregate demand" and believes fiscal stimulus is the only solution. George Soros came out to say "Quantitative easing is more likely to stimulate corporations to devour each other than to create employment." Clearly, opposition is mounting, and I believe even Bernanke understands that liquidity in the system is not the problem, the velocity of money is. Velocity is a force the Fed can do little to influence.

Frankly, I Don't Think QE 2.0 Is Coming

The Fed uses a variety of tools to achieve its objectives of price stability and full employment. The markets have very positively reacted to Bernanke's added language in the most recent FOMC policy statement, released on September 21, in which the committee stated:

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

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If we judge asset prices following the FOMC meeting, we can see that the Fed has regained an important policy tool: Language. Bernanke has written in the past about the powerful use of language as a tool for influencing market behavior. Given the Fed's willingness under Bernanke to engage in creative methods of easing, the market fully believes in the floor they are providing assets. In response, we see many assets rallying, and most importantly, we see inflation expectations rising—a good thing! The iShares Barclays TIPS Bond Fund ETF (TIP), a proxy for the return on TIPS, has surged 3.5% since the September 21 FOMC meeting.

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The break-even rate between TIPS and 30-year bonds reached 2.29% on October 6, an indication of higher inflation expectations. Treasury inflation protected securities (TIPS) are a closely watched indicator by the FOMC. Bernanke watches markets and often reacts to their demands. But, through his use of language, he is quietly achieving his goal of supporting asset prices and building in inflation expectations. There is no need for more QE if the market itself creates the outcome just by knowing the Fed is willing to fight for said outcome, inflating assets. This is good and should allow the Fed to do nothing.

In the Long Term, I’m Bearish on the Dollar Because I'm Optimistic!

Contradictory? Not in the least! I am bearish on the long-term prospects for the dollar only because I am extremely optimistic about developing countries around the world, especially the BRICs. Brazil, Russia, India, and China are the world's rapidly growing economies, marked by millions of people lifting themselves out of poverty every year and improving their lots in life. As countries around the world rise relative to the US, their currencies will appreciate against ours. I cannot say it enough: This is not to the detriment of the United States. Increased trade and higher standards of living are better for everyone. We will not be losers; our currency will simply depreciate against others as their economies grow in global influence.

I still believe the US will be a leader in innovation, but the inventions in the last few decades will allow economies around the world to make leaps ahead in the race we had to walk previously. My favorite example is the cell phone, a device that has changed the world dramatically, increasing efficiencies in communication and business. Previously, telephony was only possible after miles and miles of lines had been laid in the ground, requiring massive infrastructure investments prior to widespread usage. Now, throw up cell phone towers in key places, sell everyone cheap cell phones, and voila, you've got telephony for your entire economy! These leaps will allow developing economies to skip steps and advance much more rapidly than we ever did.

Overall, we'll see. This trade has a major catalyst coming up on November 3—the Fed's next FOMC meeting— where many believe QE 2.0 plans will be laid out. I think pessimism is far too high and there's a very realistic possibility that QE 2.0 will never occur, or at the very least, it will be lower in quantity than markets are pricing in.